Questions Over Goldman Deal as Investors Sit in the Dark

The “revolt of the Muppets” is heating up.

That’s how a Georgetown finance professor, James J. Angel, characterizes the combat by him and other investors over Goldman Sachs’ takeover of a hotel company a few years ago. (The phrase comes from a former Goldman employee, Greg Smith, who wrote that Goldman bankers referred to clients as the famous Henson puppets, a charge the bank disputed.)

The fight raises such a cornucopia of financial issues that it could shoulder an entire business school course. The holders of preferred stock in the company have taken to commenting to the Securities and Exchange Commission in outrage. Professor Angel accuses Goldman of multiple securities law violations. In essence, the question is: In these post-financial crisis days, what constitutes improper conflicts of interest?

First, some back story (and a friendly warning to readers: Goldman plays more roles in this than Joanne Woodward in “The Three Faces of Eve.”)

In 2007, a Goldman private equity fund called Whitehall took a company that runs franchised motels, like Residence Inn, private in a $2.2 billion transaction. It renamed the company W2007 Grace Acquisition. A Goldman entity, Goldman Sachs Mortgage Company, was the main lender for the leveraged buyout. Grace is run by current Goldman employees.

Goldman did not buy the publicly traded preferred shares, however. Instead, Grace went “dark,” as Floyd Norris explained last year. That meant it no longer filed financials with the Securities and Exchange Commission, a move allowed for companies with fewer than 300 shareholders. Grace delisted from the New York Stock Exchange and stopped paying dividends. It took other steps to make it difficult for anyone, including the preferred hoders, to get any information about the company. Shareholders had to request the financials from the company and, at one point, had to pay 10 cents a page for the privilege of finding out how their investment was doing. They also had to sign a nondisclosure agreement.

All of this made it onerous for a shareholder to sell the stock to another investor. Not surprisingly, the preferred shares plummeted in value. They had a value of $25 a share, but sank to a low of 5 cents. (The real estate slump and the dividend cessation probably accelerated the drop, but the opacity surely hurt, too.)

In 2012 and 2013, a mysterious entity named PFD Holdings started buying those battered-down preferred shares. In 2012, PFD was paying $3 to a little more than $5 a share. Soon after, the preferred doubled in price, and now the shares trade at about $12. As of its last announcement, PFD owns 58 percent of the preferred shares. Nice trade!

So, what is PFD Holdings? Few outsiders really know because there’s little information out there about PFD. In Grace’s news releases, the company calls it a “sister company.” In other words, Goldman is ultimately behind PFD. I asked a former Goldman executive. He hadn’t heard of it but jokingly suggested the initials stood for Pretty Fishy and Dodgy. Well, in truth he used another “F” word, but you get the idea.

A Goldman spokeswoman wrote to me that “PFD acquired those shares in two privately negotiated transactions from two groups of shareholders who approached us to sell. Any assertion we acted inappropriately is unfounded.” She added, “The claims made by the preferred shareholders are without merit. They are a matter of ongoing litigation and we are defending ourselves vigorously. We have no further comment at this time.”

If all Goldman had done was take steps to suppress information about the shares to snap them up on the cheap, that might have been troubling enough. But just wait, there’s more.

For one, Grace has not filled spots for independent directors on its board. Grace has announced meetings to hold votes on those directors, but then said the meetings failed to reach quorums. In the latest attempt last August, Grace said it was delaying yet another special meeting to vote for seats. This time, the issue was that the mysterious PFD had told the company “of its intention to consider a tender offer“ for the remaining shares it did not own “later in 2013,” according to a Grace news release.

That was good timing because this one may just have reached a quorum, given all the angry preferred holders. And then, guess what? No tender offer materialized in 2013, and hasn’t yet.

Here’s another issue: In 2009, Goldman Sachs Mortgage forgave $545 million in Whitehall’s debt, receiving mainly an option to buy control of about 80 percent of most of Grace’s hotels. Grace was in trouble, and this may have saved the company.

In 2012, Goldman Sachs Mortgage sold that option back to Whitehall for $175 million. Were these deals, in which Goldman negotiated with Goldman, fair? There do not appear to have been any independent, third-party voices involved (Goldman had ceased to be the controlling lender in 2008 and says that Whitehall’s outside investors approved the 2009 transaction). The end result of these transactions is that Goldman’s Whitehall appears to have ended up recreating its ownership in most of the hotels at a cheap price. Also, some preferred holders fear their interest in the company has been subordinated to that of Goldman’s private equity fund.

So where does the Muppet Revolt stand? Grace may have to start making its financials public again, which could bring out more detail about Goldman’s various dealings with itself. An investment adviser from Wedbush Securities requested a shareholder list from the end of the year and tallied them up. In a letter he sent to the S.E.C., he says he has counted 418 shareholders of record. That would be enough to revive the requirement to file financials.

Now we are in what Professor Angel calls the “Florida vote-counting” stage, trying to determine who should count as a “shareholder,” with Goldman’s lawyers battling against the preferred holders.

Another issue â€" I warned you that I was packing an entire semester into one column â€" is how this all comports with the Volcker Rule. Under the rule, banks are not allowed to own more than 3 percent of a private equity firm. They are not allowed speculate in securities. But there is a merchant banking exemption that allows banks to take over companies directly on a temporary basis. Is PFD permitted by the Volcker Rule? It might be helpful if some regulator asked some pointed questions.

Speaking of which, where is the S.E.C. in all this? So far, the agency hasn’t been heard from on the question of how many shareholders there are or in response to any of the allegations from the preferred holders.

When deals like this go down, I feel like we are nation of Jake Gitteses, watching big bank deals with incomprehension. In “Chinatown,” the private detective asks the wealthy baron Noah Cross: “Why are you doing it? How much better can you eat? What could you buy that you can’t already afford?”

The scary thing about this Grace deal is that the money is so small (well, relative to Goldman, at least). The preferred shares amounted to about $146 million initially. It’s almost as if Goldman does it because it can.